Beware Insider Selling In 'Small Float' IPOs

Pandora (NYSE:P) took a nosedive early Monday, down as much as 8.5% to $9.15 at one point before recovering at day's end, in anticipation of the Dec. 12 expiration on the company’s insider lockup policy in place. According to the company’s Lock-Up Agreement (p. 113) on insider selling, corporate executives, officers, and directors will now be able to cash in on their investment now that 180 days have passed since shares of Pandora were first made available to the public earlier this year.

Pandora first traded on the market on June 15, 2011. At the time, the company only offered a mere 14.7 million of its 161.9 million shares to the public. It opened up for trading at $16 a share and quickly shot up 51% to $24.20 the same day, before settling down at $17.45 by the end of trading.

By offering less than 10% of the total outstanding shares to the public, Pandora manipulated the laws of supply and demand in its favor. By only allowing just a small fraction of shares to hit the market, the company stoked an already high demand to ensure the stock price would rise. While the tactic, also known as the small float strategy, produces results, it can backfire once shares flood the market in a secondary offering.

Because of the lockup expiration, nearly 144 million shares of Pandora (roughly 89% of the total shares) are now available for sale to the public today. Now that the floodgates have opened, the influx of shares tilts the scales of supply and demand back in the opposite direction. With more shares than people want, the stock price will fall.

However, this occurs not so much because shares are actually being sold, but more so because they are technically available for sale. We don’t know precisely how much Pandora insiders are going to sell until the SEC Form 4 filings, but the fact that they can is enough for investors to cut holdings.

What’s interesting about this move is that it mimics exactly what happened to another notable Internet IPO earlier in the year, LinkedIn (LNKD). When LinkedIn’s lock-up agreement expired in the middle of last month, the total outstanding shares available doubled and the stock plummeted more than 20% in just eight trading days.

Like Pandora, LinkedIn also utilized the small float strategy by only offering 7.84 million shares to the public, less than 10% of the total outstanding shares. By doing so, it’s stock skyrocketed from $45 to more than $122 before closing at $94.25 on that first day.

There are those who would argue that while the shares offered in the IPO were lower than average, LinkedIn only did so because that was all the capital it needed. Unfortunately, that argument does not hold weight. When LinkedIn’s lockup expired, not only did insiders sell and sell big (Bain Capital sold its entire stake in the company once it could), the company also offered an additional 1.27 million in diluted shares at $71.00 in its secondary offering for “general corporate purposes.”

The secondary offering was “dilutive” in that it created new shares that didn’t otherwise exist and placed them into the market (thus diluting the existing shares). Why didn’t LinkedIn restrict its secondary offering to shares privately held by insiders?

The company is just six months fresh off its IPO and already has to create and sell new shares to raise funds for “general corporate purposes?” It is highly unlikely that executives did not forecast basic operational expenses just six months into the future. The fact is that these shares could have easily been made a part of the initial public offering held in May.

The probable reason for not doing so was because it would have increased the supply of shares by more than 16%, thereby defeating the purpose of the “small float” tactic. Instead, they manufactured the sale at a later date to take advantage of a much more expensive price - $71.00 (IPO price was $45 - a 57% increase)!

Apparently, investors have caught on to the tactics employed by these over-valued Internet companies that have surfaced as of late. The trading history of Linked In and Pandora are proof of that. Jotting down important dates such as the expiration of Lock-up agreements is now essential to trading these new fan-frenzied companies that annually fail to turn a net profit.

Examples last year include A123 Systems (AONE) and Tesla Motors (NASDAQ:TSLA), which saw their stock drop 6.4% and 15.1% respectively on the dates their lock-up agreements expired (March 29 and December 27 of 2010). Both stocks declined days before in anticipation of the expiration as well, with Tesla dropping nearly 8% the day before its 15% decline.

Next up is Zilow (NASDAQ:Z), whose agreement expires the latter part of next month. Afterward, Groupon (NASDAQ:GRPN) and Angie’s List (NASDAQ:ANGI), have agreements in place that expire in May of 2012. I recently wrote an article that calculated a good time to short Groupon based on a number of factors, one of which included consideration of its Lock-up agreement (When to Short Groupon). Zynga (NASDAQ:ZNGA) and Yelp are two more IPO darlings that are soon to be trading. Pay attention to the amount of shares they make available to the public and beware of the lock-up agreement's expiration if a small float strategy is implemented.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.